Why and how to align interests ?

Once you have invested in a private company, you can consider that you have the same knowledge about it as its management. You share their view on the company's prospects, its strengths, but also its risks (which should be considered less important than its prospects, otherwise you wouldn't want to invest in it).

Now comes the difficult part: how to ensure that all parties involved (fellow shareholders, managers, etc.) share the same objectives and will commit all resources to reach these objectives, if not outperform them? This is easier said than done.

An investor is there to support a company for a certain period, to help it grow its earnings and strategic position and then to sell his stake with a profit. The investment horizon can be of varying length, depending on the structure of the investor, but also on the degree of maturity of the company (a start-up will take longer to create meaningful value allowing for an exit either via an IPO, or via a sale to an established competitor). But all investors ultimately will seek an exit.

Even though this objective is quite straightforward, there can be multiple sources of misalignment, involving potentially all kinds of stakeholders.

First of all, between investors and management:

• Managers are human beings, with varying qualities. A great developer at the beginning of a company's story may be less apt to manage it once it has reached a certain size, where management of strategic positions is more important than continuing to focus on business development. Another manager may feel at ease in Europe, but will have difficulties as soon as his company's development plans imply travel to other continents. In essence, a person having been instrumental at a certain stage may not be in his right place at the next stage. Failing to build a structured organization allowing to pool complementary personalities and allowing to delegate responsibilities is one of the main pitfalls, certainly in start-ups, but also in companies having reached later-stage phases.

• The investor is usually best placed to see when a manager is hitting the glass ceiling. But bringing an individual to recognize such problem is very painful, and in the end can create significant turmoil in the company.

• Hence, being able to ensure since the beginning that a manager harvests the economic benefit from his contribution, even though he might not be able to remain with the company until exit is one of the main targets of the so-called "management package".

• Furthermore, this management package needs to address an inherent conundrum: managers do the brunt of the work, and hence need to be over-proportionally compensated in case of success. But on the other hand, they would not have the opportunity to be compensated if investors had not provided capital at the outset. There needs to be an equilibrium keeping all parties motivated. Plus there needs to be room for newcomers that also contribute significantly to the venture's success.

• On the other hand, investors only feel reassured when both parties risk losing money. Hence, a manager needs to be prepared to invest his own money. This is all the more important since in many countries, capital gains allow for lower taxation, and hence a manager will want to make capital gains rather than high salaries. And in a balanced management package, returns for managers are much higher than for investors. There is the golden rule of the "square of multiples": if the investor makes 2x his money, managers will make 4x, 9x if investors make 3x etc. Even though in absolute numbers, it will be less significant, it provides adequate remuneration to invest in the next project.

• This is slightly different in a start-up or even a growth company. Indeed, the founders usually withhold the majority of the company, since investors enter the capitalization table at a higher valuation. An investor will not grant a package to the majority shareholder, be it the founder and be he instrumental in the future success of the target. To some extent, the package is "built-in", since the investor accepted a high valuation while being the one to invest money (founders of start-ups usually do not invest significant financial means). This is a significant misalignment of interest, that the investor will want to cover by obtaining adequate governance rights. Such rights need to protect him in his minority position forbidding the founders from doing certain things (e.g. sell their stake without "tagging-along" the investor), but also grant the investor full information rights and, most importantly, the ability to influence, or even veto, major decisions regarding the company's operations. These usually include potential capital increases, significant investments, new hires to significant positions, but also the ability for the investor to replace members of the management team, on serious grounds. Such rights are usually regulated in the shareholder's agreement, which is a fundamental corporate document, and subject to intense negotiations ahead of the deal.

• Since they have to be negotiated, it means that people around the table do not necessarily have the same interest at the outset. Aligning interests is exactly that: find a balanced compromise allowing to then "push the cart together in the right direction". But that means that the investor needs to have proven his worth and the potential added value he brings to the table, because he will have rights that deeply interfere in the company's operations. If the other stakeholders do not perceive such added value, they will either not accept the investor, or only reluctantly, and then try to find loopholes to circumvent the agreement. In essence, treat the investor as a passive partner, such as an investor in public equities would be treated.

However, there can also be misaligned interests among shareholders. In our view, there are three main sources:

• Varying investment horizon: Not all funds have the same investment horizon, because their vehicle can be of a different vintage, or they might have invested at different times (especially in venture or growth, where people have been invested already in prior rounds). So they might have different ideas about when to exit from this investment. And having one or two shareholders in the cap table that want to exit, while others (maybe having joined the party later) still want to push forward is a recipe for turmoil.

• Varying return expectations: this is basically related to the first source. If you shoot for a lower return, you might want to exit earlier. But there might also be varying rhythms of value creation. If an investor subscribed in round A at a valuation of 10, and a new investor subscribes in round B at 50, and if the company's growth slows down, the first investor can still make a very good return, while the second one is much less happy. They can decide to exit together (but exit is complicated in a company not really delivering its plans, and hence the Round B investor might even lose money), or Round B investor sticks to the investment and it will last longer, implying varying investment horizons.

• Internal issues in each investor's organization: PE funds usually raise "closed" funds. If they have totally invested them, they need to raise a new one. In order to attract new investors (Limited Partners) or convince existing ones to subscribe again ("re-up"), they need to show performance, i.e. realized capital gains stemming from exits. So they might want to exit early from what promises to be "stars", even though these still present significant upside potential. Furthermore, some funds sell to their LPs that they are "hands-on" and "drive" their investments. But in well-managed companies, such interference can be a burden and source of considerable tension, among all stakeholders... Eventually, PE funds can also run out of money and will not be able to follow future capital injections. They might be tempted to delay necessary fund-raising rounds and hence jeopardize their investment's growth prospects or even survival. This happens quite frequently in times of crisis such as today.

In summary, investors need to ascertain -and are judged on their ability to do so- that they invest with like-minded partners, and that they are able to overcome potential opposing interests by anticipating and eliminating them before investing. But be aware, afterwards, they need to live up to the deal, because contracts such as the shareholder agreement are difficult to enforce. In the end, a Court will only decide upon potential damages, never force a company to be sold, or force a manager to accept the differing view from one investor.

We hope that you found this post interesting and look forward to the next one, where we will try to make a parallel with investors in public companies. Please send us feedback to contact@korafin.com !